17. Collins Office Supplies is considering a more liberal credit policy to increase sales, but expects that 9 percent of the new accounts will be uncollectible. Collection costs are 5 percent of new sales, production and selling costs are 78 percent, and accounts receivable turnover is five times. Assume income taxes of 30 percent and an increase in sales of $80,000. No other asset buildup will be required to service the new accounts.

a. What is the level of accounts receivable needed to support this sales expansion?

Accounts Receivable = 80000/5=16000

b. What would be Collins’s incremental aftertax return on investment?

Additional sales…………………………………………….
$80,000
Accounts uncollectible (9% of new sales)……………… 7,200
Annual incremental revenue……………………………... $72,800
Collection costs (5% of new sales)……………………… 4,000
Production and selling costs (78% of new sales)……… 62,400
Annual income before taxes……………………………... $6,400
Taxes (30%)……………………………………………….. 1,920
Annual incremental income after taxes………………… $4,480

Return On Investment = 4480/16000=28%

c. Should Collins liberalize credit if a 15 percent aftertax return on investment is required? Assume Collins also needs to increase its level of inventory to support new sales and that inventory turnover is four times.

Collins should liberalize credits if a 15% aftertax return on investments is required because Collins would see a 28% return on investments.
d. What would be the total incremental investment in accounts receivable and inventory to support an $80,000 increase in sales?

I understand how to do most of this one, but what I can't figure out is how to find the incremental investment on inventory. If someone can help me on this part alone, I can get the rest.

e. Given the income determined in part b and the investment determined in part d, should Collins extend more liberal credit terms?

No need to help with this one cause once I understand the incremental investment on inventory, I can get the rest of D and answer this one.

Quote:

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Originally Posted by domomule

d. What would be the total incremental investment in accounts receivable and inventory to support an $80,000 increase in sales?

I understand how to do most of this one, but what I can't figure out is how to find the incremental investment on inventory. If someone can help me on this part alone, I can get the rest. No need to help with this one cause once I understand the incremental investment on inventory, I can get the rest of D and answer this one.

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The 'incremental' investment in inventory is just the amount by which inventory must increase over its current level, in order to support the sales expansion.

To calc this amount we'd normally figure that if inventory turns 4 X, it means that inventory averages about 1/4 of annual COGS. Thus if annual COGS were to increase by, say, 12, we'd know inventory would increase (or 'increment') by 3.

In this problem, though, we're not given the COGS explicitly. We're told that "production and selling costs" are 78% of sales, but that seems to lump COGS in with some other expenses.

I'd suggest the following: In some texts, the phrase "inventory turns" is expressed as the ratio of Sales : Inventory, rather than COGS : Inventory. So look back in the material preceding this question to verify if this is in fact the case.

If so, you'll just use the given facts that [a] Sales will increase by 80K per year; and [b] "inventory turns 4 X" just means that the company normally carries an inventory on the balance sheet equal to 1/4 of its annual sales.

If I can interrupt this a second... can we please not post in that light blue color? It's very difficult to read. I did, in fact, skip over this post last night cause I didn't want to try to read that.

Good point.

Domomule, I really like your using that method to distinguish your work on the problem from the questions themselves. A choice of a darker color, though, would have really enhanced the clarity.

But I'm the guiltier party... when I quoted your excerpt, I didn't pay attention that it would put your light blue text onto a light blue background... my bad.

Basically, you would add up the accounts receivable and the inventory.
20,000 + 16,000 = $36,000

$36,000 is the total incremental investment.